Stopping Deflation: The Power of Negative Thinking

I'm not convinced that mild deflation is anything to worry about. It didn't seem to hold back the U.S. economy during the post Civil War, pre-Fed era. But suppose you were worried about it. What could be done to reverse it? The standard answer is for the central bank to cut interest rates. But what if the central bank has already cut interest rates down to 0%, and deflation persists?

Dinosaur Keynesians have long said that under these circumstances, monetary policy is helpless. Expanding the money supply is like "pushing on a string." But the best modern macroeconomists see through this error. Ben Bernanke lists quite a few ways to make monetary policy more expansionary when the nominal rate hits 0%:

"One approach... would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates."

"A more direct method... would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields."

"A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices... A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money."

To repeat, I'm not convinced mild deflation is a problem worth solving. But thinking about Bernanke's speech made me realize that there is a simpler to make monetary policy more expansionary when the nominal rate equals 0%. And that is to cut rates again. If the rate of monetary growth is too low when the interest rate is zero, pick the negative interest rate that gives you the rate of monetary growth you want.

Under normal circumstances, of course, negative nominal rates are a recipe for hyperinflation. But when inflation is -1%, the real interest rate on a -.1% rate loan is +.9%. Borrowing to invest under these conditions is not a no-brainer. You can pay back less than you borrowed, and still be poorer afterwards.

How about borrowing to hold? You borrow $100 at -.1% interest, and repay $99.90 in a year, earning $.10 free and clear. That would indeed be a no-brainer if there were no transactions costs. But there always are. The upshot, then, is that mildly negative rates - just negative enough to exceed the transactions costs of a decent number of borrowers - would have a large but finite expansionary effect. If you were still worried about hyperinflation, you could treat the negative interest rate as a "sale price" that expires after a couple of days, or after x billions of extra dollars have been borrowed.

Rockwell called Bernanke a "crank" for engaging in this kind of thinking. And if I were advocating a negative interest rate right here, right now, a crank is what I would be.

But I'm not advocating anything. I'm just pointing out that the "liquidity trap" is even less worth worrying about than modern macroeconomists realize. It might seem like monetary policy runs into a wall when interest rates reach 0%. But this "wall" is made out of paper, not brick. You may not want to visit the negative interest rates on the other side, but getting there is easy.

I don't see the problem; the Fed can print as much money as it likes, and cause as much inflation as it likes. If it can't loan money at 0% because it's already bought all outstanding bonds and satisfied all loan demand (unlikely - currently debts outstanding are two orders of magnitude greater than currency in circulation), then it can start buying real property - gold, land, etc.

I was always under the impression that a negative interest rate is impossible.

The argument is simple. If I just hold cash, I get a 0% nominal interest rate; my real interest rate is the opposite of the inflation rate. I can only be persuaded to deposit my money somewhere if they offer a positive nominal interest rate. Deflation means that people get a positive real interest rate just by holding cash. That discourages them from saving and investing.

Is a negative nominal interest rate possible? How would saving and lending operate, and why would they happen?

This would indeed be a solution if the liquidity trap was an artefact of the fact that nominal rates cannot go below zero. However, it isn't; this mistake was introduced (I think) by Tobin and popularised by Paul Krugman. Liquidity traps can arise at any level of nominal or real rates if firms' anticipated demand schedule for their product ("effective demand" in the language of the General Theory) is such that they prefer to hold liquid resources rather than buy investment goods.

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